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For the past decade, 30-year mortgage rates have stayed mostly below 5%.1 Most home buyers opted to take out fixed-rate mortgages to lock in these historically low rates.2
But rates increased sharply in 2022,3 meaning higher monthly payments for buyers. For some would-be buyers, these higher rates pushed home ownership out of reach. Could an adjustable rate mortgage (ARM) be a good option?
What Is an ARM?
Before considering an ARM for a home purchase or refinance, you should understand what this type of loan is. Simply put, an ARM is a home loan with an interest rate that may change. ARM rates are generally linked to a fluctuating index. If the rate goes up, your monthly payment gets bigger. If the rate declines, your monthly payment may get smaller.4 By contrast, if you take out a fixed rate mortgage, your interest rate and monthly payment will stay the same, year in and year out, for as long as you hold that loan.
There are several types of ARMs. One popular type, known as a hybrid ARM, starts with a fixed rate for a set period, then switches to an adjustable rate. For instance, a 5/1 ARM has a fixed rate for the first five years, then adjusts once a year after that. A 5/6 ARM also starts with 5 years at a fixed rate, then adjusts every 6 months.5
ARMs Have One Big Advantage
Why would anyone take out a loan with a fluctuating interest rate? The main attraction: ARMs usually offer a lower starting rate. For instance, as of December 2022, the average rate for a 30-year fixed mortgage was 6.5%. A 5/1 ARM averaged 5.45%.6 If you chose an ARM over a fixed rate today, you would save money every month for the first five years of your loan.
But what about when the rate begins to fluctuate? Of course, there's a chance that the index your loan is tied to goes down, in which case, you're in luck. However, chances are that at some point in the life of your loan, your interest rate will increase.
Caps Protect ARM Borrowers – to an Extent
So, how much will the rate potentially increase? That depends on two things: how much the index rate increases and your loan's adjustment caps.
This cap is one of the most important details to understand in the terms of your ARM. For instance, an ARM may have a 2% cap on periodic rate increases. This means that if your 5/1 loan starts out at 5.45%, the highest it could adjust to at the end of five years would be 7.45%. It could increase another 2% annually after that. However, it won't go up infinitely, because virtually all ARMs also have a lifetime cap,7 usually 5%.8 This means that if your loan starts out at 5.45%, the highest interest rate you could ever be charged is 10.45%.
Even with caps, it's possible – even likely – that if you choose an ARM, your payments will eventually be higher than they would have been if you'd taken out a fixed rate mortgage. Given that eventuality, are ARMs ever a good idea?
In some circumstances, yes.
When an ARM Might Be a Smart Move
If any of these scenarios sound like you, you might want to discuss the ARM option with your lender.
- You plan to sell the home before the end of the fixed rate period. Say you are buying a home in the neighborhood of your child's high school, but you plan on moving as soon as they graduate. If you know you'll be putting your home on the market within a few years, you might feel comfortable taking out a 5/6 ARM and enjoying the lower rate for those few years.
- You plan to refinance at the end of the fixed period. Some buyers take out a hybrid ARM in order to enjoy the lower rate for a few years, then refinance to a fixed rate loan. This plan may be attractive to you if you think rates are unusually high at the time of your purchase and you hope they will go down soon.
- You expect your income to increase. Say you or your spouse are currently working part time but plan to start working full time in a few years when your kids are older. Because of this, you expect to be able to make larger mortgage payments in the future than you can today. In this case, an ARM may be a way to get into the home you need now, while keeping your payments in line with your current income for now.
No matter what type of mortgage you choose, make sure you read all the fine print and understand the terms of your loan. Compared to fixed rate loans, ARMs can have more complexities to understand, with rules and potential fees that may be unfamiliar.9
A good resource to make sure you understand your loan contract is The Consumer Financial Protection Bureau's Mortgages page. You should also thoroughly discuss your loan options with your lender and make sure they answer all your questions.
And if you have questions about how homebuying works, working with a First Horizon loan officer can demystify the process. Get in touch today to learn how we can help.
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1 Federal Reserve Bank of St. Louis. "30-Year Fixed Rate Mortgage Average in the United States." Accessed January 2023.
2 CoreLogic. "Is the Adjustable-Rate Mortgage Making a Comeback?" Accessed January 2023.
4 The Federal Reserve Board. "Consumer Handbook on Adjustable-Rate Mortgages." Accessed January 2023.
6 BankRate. "Mortgage Industry Insights." Accessed January 2023.
7 Experian. "Common Types of Adjustable-Rate Mortgages." Accessed January 2023.
8 Consumer Financial Protection Bureau. "With an adjustable-rate mortgage (ARM), what are rate caps and how do they work?" Accessed January 2023.
9 NerdWallet. "Adjustable-Rate Mortgages: The Pros and Cons." Accessed January 2023.